Interest Rates 101 - Series 2

April 23, 2014 10:54AM CDT

If you missed Interest Rates 101 Series 1, you can find it here.

Most investors and traders care about future interest rates, but none more than future traders of stock index futures, interest rate futures, and currency futures. If you are considering a trade in any of these markets, you must ask yourself, “Do I think interest rates will rise in the future?” If the answer is “yes” then you probably want to avoid being long interest rate futures, or have some information between prevailing interest rates and yield duration (maturity) from short-term to long-term maturity rates.

Long Rates Tend to Follow Short Rates, Somewhat
Technically, the Treasury yield curve can change in various ways: it can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).

Consider two observations. First, the two rates (long rates vs. short rates) move up and down somewhat together. Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in magnitude. Specifically, when short rates rise, the spread between 10-year and one-year yields tends to narrow (curve of the spread flattens) and when short rates fall, the spread widens (curve becomes steeper). In particular, the increase in rates from 1977 to 1981 was accompanied by a flattening and inversion of the curve (negative spread). The drop in rates from 1990 to 1993 created a steeper curve in the spread, and the marked drop in rates from March 2000 to the end of 2003 produced a very steep curve by historical standards.

Supply-Demand Phenomenon
So what moves the yield curve up or down? Well, let's admit we can't do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon.

In the upcoming series, I will be looking at fiscal policy, and supply-related factors. In the last of these series, I will be looking at demand-related factors inflation and fundamental economics

There have been entire volumes of textbooks written on interest rates, this report just scratches the surface. Futures trading is one of those fields where everyone has a different theory on what works and what doesn't. If we can leave you with one last tip, it is to back test whatever strategy you decide to pursue. Back testing means looking back at several years' worth of charts to see how a particular futures contract reacts. Different futures markets do different things, so be sure to do your homework first. If you are new to the futures markets and don't have a solid understanding of these markets, I recommend you contact me.

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